Lecture 4: The Recession of 1990 and its Legacy

Finance excess saw boom turn to bust, and Australia experience its third recession in a quarter of a century. Then-treasurer Paul Keating would infamously observe it was 'the recession we had to have.' Perhaps it was—or was it caused by overly tight monetary policy?

Alternatively, did the macroeconomic policy of the time lay the foundations for the 15 years of prosperity and relative stability that was to come?

Transcript

This year's lecturer is outgoing Reserve Bank Governor, Ian Macfarlane and his lectures are titled The Search for Stability. They're an overview of the economic evolution of the world's economies, and particularly our own since World War II.

In last week's lecture, Reform and Deregulation he examined the financial excesses that came to define the 1980s, and the inevitable collapse that followed. By 1990 our good times were over, and for most of the world's developed economies, recession was once more the order of the day. Australia was not immune.

Then-Treasurer Paul Keating infamously observed it was 'the recession we had to have'. Well, perhaps it was, but was the policy response to those financial excesses too much, too soon? Or did macro-economic policy as it was applied at the time, lay the foundations for the 15 years of prosperity and relative stability that was to come, and indeed, is still with us?

The 1990 Recession and its Legacy, the fourth in this year's Boyer Lectures. Here's Ian Macfarlane.

Ian Macfarlane: In the early 1990s, Australia went into a recession whose origins have been a matter of dispute and whose legacy remains with us. My own views about its origins have been set out on several occasions, but in short, I believe that the financial excesses of the 1980s reached such a scale that the 1990 recession was inevitable.

In this lecture, I want to discuss the recession and its subsequent political and economic significance for Australia. These remain contentious issues and still have the power to influence political positions.

At the end of the 1980s expansion, the Australian economy was over-stretched on a number of ways. By the second half of 1989, GDP was rising by over 5% and domestic demand by 8%. The strongest components of spending were imports, which were rising by 29% and commercial construction, at 22%. At the same time, inflation was 7-1/2%. More importantly, the corporate sector was heavily geared, and yet its borrowing was still rising at 17% per annum, despite interest rates being at very high levels. Prices for all classes of property, commercial, industrial, retail and residential, had risen to exceptional heights. The country was therefore extremely vulnerable to any contractionary shock to the economy itself, or to confidence.

The shock duly came in the form of the international recession of the early 1990s. Again, as in 1974 and 1982, Australia participated. The early 1990s international recession came in two waves, with the United States, the United Kingdom, Canada, Australia, New Zealand, Finland and Sweden, going into recession in 1990, followed by the Continental European countries some time later. Given the over-stretched economic situation in Australia, and the international recession, our participation was inevitable.

Some people may be surprised by this, but I should point out that I'm in good company, since most economists and outside observers who have analysed the period in any depth, come to the same conclusion. Unfortunately, it remains a very controversial subject and one where political feelings still run high. In large part, this is because so many people associate it with Treasurer Keating's catchphrase that 'this was the recession we had to have'. In his 1992 assessment, Paul Kelly said of the Keating phrase 'It was perhaps the most stupid remark of his career and it nearly cost him the Prime Ministership. However, it is largely true. The boom begat the recession.'

Two years earlier, Alan Wood had made a similar point when he said, 'Once a decision was taken to correct the excesses, a recession became inevitable and necessary. Policy simply cannot fine-tune the economy into a soft landing from such dizzy heights.'

Others have also made the same point. In doing so, I do not believe they were trying to absolve the government or the Reserve Bank from responsibility for what happened in the period, but were merely saying the big mistakes were made in the mid to late 1980s, not in the early 1990s, when the recession occurred. As I said in the last lecture, this is a view with which I agree, and I intend to spend most of this lecture examining the recession and its significance for Australia's subsequent economic and political development.

The first step in this direction is to put the Australian recession into international perspective. Of the 18 oeCD countries of reasonable size and development, 17 experienced a recession in the early 1990s, a similar situation to the mid-1970s and early 1980s global recessions. Of the 17 countries that had a recession, 10 had a larger fall in GDP than Australia. The deepest recessions were in two countries that had had recent financial deregulations, Finland and Sweden, followed by Canada, New Zealand, Belgium, Spain, Switzerland, United Kingdom, Italy and Germany. Australia was thus in the middle of the field, its fall in GDP of 1.7% was similar to the weighted average fall of 1.8% for the oeCD area.

The countries that experienced a milder recession than Australia were Japan, Denmark, the United States, France, the Netherlands, and Austria.

Why did all these countries, particularly the Anglo Saxon and Scandinavian ones, have a recession in 1990? There are two main reasons: First, any boom built on rising asset prices financed by increased borrowing, has to end. The further asset prices rise above their intrinsic value, the more likely it is that a reassessment will be made and they will stop rising. At this point, there was a rush for the exists, as everyone wants to sell before prices fall. The situation is usually made worse by banks wishing to call in loans, or refusing to roll them over as they react to falling collateral values. This is the classic dynamic of an asset price boom and bust, such as that which occurred in Australia.

Although we will probably never know the exact event that caused the reassessment, one likely candidate was the realisation that the world economy was in the process of slowing. This also helps to explain the simultaneous downturn in so many countries.

The second factor was the relentless pressure of high interest rates on businesses, which in many cases were borrowed up to the hilt. The aim of the high interest rates was to slow the economy, by discouraging further borrowing, particularly by businesses. In this way, monetary policy would also contribute to any of the asset price boom. The combination of high levels of debt and high interest rates also constrain cashflow, and limited firms' ability to undertake investment and increase employment. At the same time, households were being affected by the rise in mortgage interest rates which reduced their disposable income available for consumption.

Now I don't think anyone disputes the proposition that monetary policy had to respond to the overheating of the economy and the asset price boom of 1988 and 1989. In the event, the cash rate reached 18% in the second half of 1989, the mortgage rate 17% and many loans to businesses were well in excess of 20%. The issue is whether monetary policy was tightened excessively, and whether this is what caused the 1990s recession.

Of course there is an equally plausible alternative view which is that if monetary policy had been tightened by less, then the asset price boom would have been bigger and lasted longer, which in turn would have been followed by a bigger bust. It is the former of these two views however, which has become the popular explanation for the 1990s recession, and it is the one I intend to discuss and take issue with, although we will never know with any certainty which view is closer to the truth.

Looking back from our present vantage point, the cash rate of 18% that prevailed in the second half of 1989 seems exceptionally high. Little wonder that people see it as the single cause of the recession. But we have already seen that rates as high as this, or nearly as nigh, had little effect in stopping the rapid growth of credit earlier in the 1980s. It is difficult today to appreciate just how different things were in the high inflation period particularly when it was combined with a competitive banking system eager to land. In fact short term interest rates of 18% were not unprecedented. They reached nearly 20% in December 1985, and were more than 21% in April 1982 and at a similar level, briefly, in May, 1974.

Thus if we judge the tightness of monetary policy by the level of short-term interest rates, 1989 was the fourth time that we had been in this position. One difference however, is that in 1989 mortgage rates had been deregulated, and so for the first time, some of the tightness of monetary policy flowed through to the household sector. The reason only some of it flowed through was that all mortgages made before 1986 were grandfathered, or capped, at 13%.

The emphasis on interest rates and deregulation at least reminds us that what we are dealing with is essentially a financial event. Just as the expansion of the 1980s was dominated by the rapid growth in credit and asset prices, the recession of 1990-'91 was dominated by financial failure. In most cases, it was the fall in asset prices that meant that loans could not be reoa8ud, thus transferring the distress to financial institutions. It is the only post war recession to have this character. A good indication of the fall in asset prices is provided by the price of office buildings., most of which are purchased or developed using very large amounts of credit. Between their peak in 1989 and the trough in 1993, the average price of office buildings halved. Clear evidence that their previous rise was a bubble is given by the fact that even now, in 2006, prices have not regained the level they were in 1989. They are still about 15% below that peak.

In the process of unwinding various insolvent businesses and property projects a number of financial institutions failed. These included the State Bank of Victoria, the State Bank of South Australia, the largest credit union, the Teachers' Credit Union of Western Australia, the second-largest building society, the Pyramid Building Society, several merchant banks, Tricontinental, Rothwell's and Spedley's, a mortgage trust, Estate Mortgage, and a friendly society, the Order of the Sons of Temperance. In addition, a number of well-known businesses that had been bought by highly geared acquirers, had to be sold in distressed circumstances, and two of the Big Four private banks incurred losses and had to be recapitalised.

You would have to go back to the 1890s to find a downturn that was so heavily influenced by financial failure of systemic proportions. Of course, the damage was not confined to the financial sector, as businesses and households cut spending and unemployment rose, as is usual in recessions. The recession started in the September quarter of 1990 and lasted until the September quarter of 1991. During the recession, GDP fell by 1.7%, employment by 3.4%, and the unemployment rate rose to 10.8%. Like all recessions, it was a period of disruption and economic distress. It was particularly deep in Victoria where a disproportionate share of the financial failure had occurred. Victorian employment fell by more than 8% compared with a fall of 2% for the rest of Australia.

It is often asserted that it was Australia's deepest post-war recession, but I do not know the basis for this claim. Certainly in terms of the usual measure, the fall in GDP, it was less deep than the 1982 recession when GDP fell by 3.8%.

My reading of the multitude of ways by which you could judge the depth of recessions is that most show it to be less severe than the 1982 recession, and somewhat similar to those of 1961 and 1974. Its memory however is still clear and it is often evoked in political and economic debate. It is the only recent economic episode to have been covered extensively in a number of books.

One issue that is often raised is who was responsible for the high interest rates of 1989 and the pace of their reduction from January 1990 onwards. Was it Paul Keating? Was it the Reserve Bank? Or was it the Treasury?

There has been a lot of speculation about this in the various books that deal with the period, and much is made of small differences of opinion. But my conclusion is that all three parties agreed with each other. No-one involved disputed the need to raise interest rates to the high level they reached in 1989, and no-one argued for an earlier reduction from 1990 onwards. None of the three parties had sought to disassociate themselves from the monetary policy that was pursued throughout the period. However it's true that there were differences in the reasoning behind each party's support of the policy. For example the balance of payments figured more prominently in the thinking of the Canberra-based parties, as demonstrated by Treasurer Keating's reaction upon hearing Deputy-Governor Phillips' remark in 1990: 'It was blindingly obvious that while tighter monetary policy reduces spending and therefore imports, which is good for the current account, higher interest rates do tend to hold up the exchange rate. That is good for inflation, but not what exporters or those competing with imports would like. This illustrates the point that monetary policy is not an effective weapon to fight a balance of payments problem.'

There was one enormously beneficial legacy of the 1990s recession: a significant reduction in inflation. There had been falls in inflation after the 1970s and 1980s recessions, but the falls were not large enough to leave us with an ongoing low rate of inflation. This time, inflation fell to around 2% which meant that for the first time in 20 years, Australia had an inflation rate that was in line with the world's best practice. We had become a low inflation country. It is interesting to speculate on why this was achieved in the early 1990s when it had not occurred after the earlier two recessions.

The immediate reason is that inflationary expectations were finally broken. There was a survey on inflationary expectations that has been conducted by the Melbourne Institute of Economic and Social Research since the early 1970s. This survey asked ordinary people what they think inflation will be over the next year. It moved up in the 1970s and remained stubbornly around 10% all through the 1980s. The one significant movement in the series was a sharp fall in 1991, which pushed it below 5% where it has remained since.

Other indicators of inflationary expectations derived from financial markets show the same pattern of a sharp break in 1991. Why did inflationary expectations finally fall then? I think there were two reasons: first, the falls in asset prices, including house prices that were occurring, reminded people that prices can fall as well as go up. Second, I think the policy response was different in the 1990s. In earlier recessions, all the policies and all the government rhetoric were pointed towards re-expanding the economy as quickly as possible and reassuring the public that all efforts were being made to cushion the blow. In the 1990s recession, while the budget moved into deficit and interest rates were reduced, these moves took place in a measured fashion, and by 1991 all the government and Reserve Bank rhetoric was about the once-in-a-generation opportunity to return Australia to being a low inflation economy. It is significant that in March 1991, in the middle of the recession, the government was prepared to announce a further phased reduction in tariffs, a move that would reduce inflation but do nothing to support the economy. Similarly, the rate at which interest rates were cut was influenced by the need to avoid a collapse in the Australian dollar. It was allowed to fall, but not by an amount that could have jeopardised our success in reducing inflation.

The events in Australia were mirrored elsewhere. The laggard countries, those which had failed to return to low inflation after the early 1980s recession, did so in the early 1990s. This group, which in addition to Australia included the United Kingdom, Canada, New Zealand, Sweden and Finland, all experienced recessions followed by a long period of low inflation. They also formed the core group that adopted the monetary policy regime of inflation targeting, a subject I will take up in the next lecture.

The experience throughout the developed world in the three decades that I have covered in the first three lectures demonstrates an unfortunate but inescapable fact: no country with an entrenched inflation problem has significantly reduced inflation without it occurring in the context of a recession. While everyone would like to find a softer way of doing so without incurring higher unemployment, no-one has found such a way. The hopes that prices and incomes policies or wage tax trade-offs, or whatever would be up to the task, have been abandoned.

I don't want to give the impression that policymakers knew exactly what was happening, or that they were in control throughout. We clearly didn't set out to have a recession in order to reduce inflation back to a satisfactory rate. The recession happened because of the unwinding of the excesses of the 1980s, the international recession of the early 1990s and high interest rates. But once it was apparent that this was going to happen, it was realised that there was an opportunity to achieve something of lasting value out of these unfortunate events. However not everyone was convinced. There were many economists and other commentators who felt that as soon as the recession ended, inflation would bounce back to its former level. In the event, they were wrong, which was fortunate for the future health of the Australian economy.

I would now like to turn to the subject of how the recession of 1990 is viewed by the public in retrospect. In the United States, the Volker disinflation of the early 1980s is viewed, at least by the economics profession, as a successful example of economic policy which yielded long-lasting benefits despite its short-term costs. In Australia however, the equivalent disinflation of the early 1990s tends to be viewed as a monetary policy mistake and there was a widely held view that those politically associated with it will continue to suffer an electoral disadvantage. Why is there such a big difference in perception between the two countries?

An important explanation is that in the United States the principal author of the policy was not a politician, but a public official, Paul Volker. There was thus no long-standing electoral advantage for either political party in continuing to criticise his actions. This is even more so since the period of the Volker disinflation overlapped both the Carter Democratic Administration and the Reagan Republican Administration. In Australia's case, the main author of the policy was seen to be Paul Keating, and the whole episode occurred during the Hawke-Keating Labor government's period of office. This has given the succeeding Howard government the opportunity to repeatedly criticise its predecessor by drawing attention to the high interest rates and ensuing recession.

But was the period itself as damaging politically as we now remember it? I think not. Remember, the Whitlam government was voted out of office at the first opportunity after the 1974 recession, and the Fraser government was similarly voted out in 1983 after the 1982 recession. In contrast to this, Bob Hawke was able to defeat Andrew Peacock in 1990 immediately after the peak in interest rates. The cash rate was still 16% at the time, and Paul Keating defeated John Hewson in 1993 two years after the recession ended. It was not until 1996 over six years after the peak in interest rates, that the Keating government was defeated. The Hawke-Keating governments were the only recent Australian governments that experienced a recession and were not voted out of office at the first opportunity. There is no doubt that they suffered a fall in popularity, as governments always do after a recession, but they survived. Thus the public perception of events at the time must have been less hostile to the government that subsequent history has portrayed it.

Another interesting feature of the time is that throughout the 1988 to 1993 period, the Coalition opposition consistently argued for a monetary policy framework that was more hardline, essentially the New Zealand model, than that which the government supported. It is hard to believe that they would have done this if the public resentment of high interest rates was as overwhelming as is now portrayed.

The reason it has been so easy to portray the late 1980s and early 1990s as a period of great public resentment and hostility to government, was brought home to me when I attended a lecture by the political adviser and pollster, Lynton Crosby. He had recently been working for the British Conservative party and his polling had discovered that it lacked economic credibility compared with its opponents, the incumbent Blair Labour government. People associated the Conservatives with the turbulence of their period of office up to the mid-1990s, and contrasted this with the economic stability that has prevailed since then under the current government. There is thus an enormous political advantage in being the incumbent during the recent decade of economic stability whichever side of the political fence you are on. People who have now enjoyed 15 years of low inflation and continued growth, find it difficult to understand the previous era of high inflation and high interest rates. It is not surprising that some are fearful when the possibility of its return is drawn to their attention.

But to return to some longer-term issues. There are a number of lessons that the economics profession learned from the nearly 50 years of experience I have described so far in these lectures. The first realisation was that while high inflation was costly, and that it prevented sustainable economic expansion, it was also extremely costly to eliminate. Therefore the lesson going forward was that the biggest contribution economic policy could make was to prevent a return to high inflation so that we do not have to eliminate it again.

The second important lesson that was learned was that a better framework for demand management, particularly better monetary policy, was the key to a better inflation outcome. The story I have chronicled in the first three lectures provides much of the evidence for this. The Volker disinflation, the later disinflation of the laggard countries, and the fact that throughout the whole inflationary period, countries such as Germany and Switzerland which had run conservative monetary policies, had relatively lower inflation.

A third development was that agreement was starting to emerge on what constituted good demand management policy, particularly monetary policy. The differences of view between left and right or between Keynesian and monetarist were narrowing, and were later to almost disappear as is shown by the fact that these days the macro-economic policy proposals of the two major parties are almost identical.

By the early 1990s most economists had accepted that monetary policy's main purpose was to maintain low inflation. Although monetary policy should also contribute to smoothing the business cycle, it was recognised that this was not enough. There was a big difference between smoothing around an average inflation rate of say, 2% and smoothing at double digit rates. Another way of expressing this point was to say that monetary policy needed what economists refer to as a nominal anchor. Its ultimate objective had to be something expressed in nominal terms, such as the rate of inflation or the rate of growth of nominal GDP. It could not use a real variable such as read GDP or the unemployment rate as its guide, as we saw from the instability of the Phillips Curve.

While actual inflation is very important, inflationary expectations are just as important. The monetary policy regime has to establish an environment where people expect inflation to remain low and can base economic decisions on that expectation, such as entering into longer-term wage contracts, or borrowing or lending for longer terms. Alan Greenspan defined low inflation as being low enough, so that people's economic decisions were not materially influenced by inflation. He has never put a number on it, but most people think it is around 2% or 2%-3%.

Finally, the operation of monetary policy is based on the central bank's power to determine short-term interest rates through its control over the cash rate. This rate has to be moved from time to time in a pre-emptive manner if it is to prevent the emergence of inflation, not just react to it after it has become entrenched. Similarly, it has to be lowered where necessary in a pre-emptive manner although this is easier to achieve. The need for early action well before the cases become clear to all, says something about who should be making the decision, and leads to the issue of central bank independence, a subject that was becoming widely discussed around the world in the late '80s and early '90s.

On fiscal policy, ideas were also evolving, and like monetary policy, the emphasis was shifting towards a medium-term perspective. While incurring deficits during a recession is still regarded as sensible policy, there was now more focus on offsetting these in the good years with surpluses, and more concern with the sustainability of the government's debt position in the long run.

In Lecture 5, we will see how these general principles of demand management were made operational over the following 15 years.

Geraldine Doogue: Ian McFarlane, with the fourth in this year's Boyer Lectures.

Next week, The Long Expansion. Through the 1990s sustained economic growth re-emerged, and policymakers took a once-in-a-generation opportunity to return Australia to being a low inflation economy. So that's next week.

The Boyer Lectures are produced by Scott Wales, with technical production by Jennifer Parsonage.